TAX TREATIES - International scenario and India relevance Amarpal S. Chadha

1. TAX TREATIES - International scenario and India relevance Amarpal S. Chadha

2. Overview • Introduction • Treaty models and India’s Tax Treaties • Aids to Interpretation • Interpretation of treaties • Operation of treaties

3. Introduction

4. Why does double taxation occur • Tax systems generally followed • Residence based tax system • Connecting factor is “residence” • Unlimited taxing rights due to “personal attachment” of persons • Source based tax system • Connecting factor is “income” • Limited taxing rights due to “economic attachment” of persons • Double taxation occurs in situations where the country of residence and the country of source seek to tax the same income • Also, certain countries tax world-wide income of their citizens, irrespective of their being residents of other states e.g. USA

5. Types of double taxation • Economic double taxation • Same economic transaction, item or income is taxed in two or more states during the same period but in the hands of different taxpayers • Trust – income taxable in the hands of trust in one contracting state and in the hands of beneficiaries in the other contracting state • Partnership – income taxable in the hands of partner in one contracting state and in the hands of partnership in the other contracting state • Juridical double taxation • Two or more states levy taxes on same entity or person on same income for identical periods eg., one contracting state taxes on resident basis and the other on source basis • Is the result of a conflict between two tax systems • Arises due to overlapping claims of tax jurisdictions on interrelated economic activities • Tax treaties prevent/mitigate juridical double taxation

6. Remedy from double taxation in India • Section 90 • Tax payer has the option to be taxed under the provisions of the tax treaty or the domestic tax laws, whichever are more beneficial • CBDT Circular 333 - Specific provisions of the tax treaty override the general provisions of the domestic tax laws • In other cases, domestic tax laws will apply • Section 91 • Relief from double taxation in countries with which India has no tax treaties • Person resident in India is allowed credit of foreign taxes paid against amount of Indian taxes

7. Types of treaties • Comprehensive treaties – Deals with all possible sources of income • Limited treaties – Deals with only certain sources of income • DTAA between India and Pak is limited to air transport only

8. Objectives of a tax treaty • Elimination of double taxation • Promotion of mutual economic relations, trade and investment • Certainty on nature of income and quantum of tax payable irrespective of tax laws of overseas state • Establishing the right of a country to tax any income stream • Exchange of information to combat tax avoidance / tax evasion

9. Steps in which a tax treaty comes into force • Negotiation of a tax treaty • Drafting of the articles • Signing • Ratification • Notification • Coming into effect Key dates • Ratification - Formal confirmation by each contracting state, that the constitutional requirements for implementation of agreement are fulfilled • Entry into force in India - Generally computed from the date of notification in the Official Gazette • Coming into effect - The period as specified in the treaty once the treaty is notified

10. Treaty models and India’s tax treaties

11. Why Model Conventions are required • The rationale of the preparation of bilateral tax conventions was cogently expressed by the Fiscal Committee of the League of Nations in the following terms: "The existence of model draft treaties...has proved of real use...in helping to solve many of the technical difficulties which arise in [the negotiation of tax treaties]. This procedure has the dual merit that, on the one hand, in so far as the model constitutes the basis of bilateral agreements, it creates automatically a uniformity of practice and legislation, while, on the other hand, inasmuch as it may be modified in any bilateral agreement reached, it is sufficiently elastic to be adapted to the different conditions obtaining in different countries or pairs of countries”

12. Treaty models and India’s tax treaties • Treaty Models – Operation and Benefits • OECD Model • UN Model • US Model • India’s tax treaties

13. How do Model Tax Treaties work • Model Treaties contain classification and assignment rules (collectively known as distributive rules) • For income subject to tax under domestic tax laws of both countries • Distributive rules contain more than 14 categories of income to cover entire tax base • Standard Articles; May be amended by negotiation • Model Treaties distinguish income under each Article and specify the State which has the right to tax • Either Source State or Residence State get exclusive or limited right to tax • If states share taxing rights they share cost of eliminating double taxation • Model Treaties allocate taxing rights but don’t make tax rules

14. Benefits of Model Tax Treaties • Facilitate International Trade and investment • Provide internationally accepted format for drafting and negotiation of bilateral agreements • Provide for a negotiated division of taxing rights over foreign source income • Provide certainty over source rules • Assure stability for international investors • Eliminate discriminatory taxation of foreign nationals and nonresidents • Prevent tax evasion • Avoid excessive taxation in source state • Assist global tax planning

15. What is OECD? • Organisation for Economic Cooperation & Development • The OECD is a unique forum where the governments of 32 democracies work together to address the economic, social and environmental challenges of globalisation. • The OECD is also at the forefront of efforts to understand and to help governments to respond to the new developments and concerns, such as corporate governance, the information economy and the challenges of an ageing population. • The Organization provides a setting where governments can compare policy experiences, seek answers to common problems, identify good practice and work to co-ordinate domestic and international policies.

16. OECD model • Organisation for Economic Co-operation and Development (OECD) • Established in 1961 with developed countries as its members • Essentially a model treaty between two developed nations with comparable tax systems and tax objectives • Advocates residence principle • Lays emphasis on the right of state of residence to tax • India not a OECD member • Currently has been granted the “Observer” status

17. OECD Member countries

18. OECD Member countries (Cont.)

19. OECD Significance as regards India • 2001: Member of Technical Advisory Group on E-commerce Tax Treaty Characterization Issues • July 2006: Granted ‘Observer Status’ • May 2007: Offered enhanced engagement with a view to possible membership • July 2008: India’s positions included in the non-member country positions’ section of the 2008 Update • Extensive reliance placed by Indian Courts/Tribunals while interpreting tax treaties

20. India’s position on OECD MC & commentary - PE • Deviations on several aspects in definition and on commentary, some key aspects:

21. India’s position on OECD MC & commentary - PE

22. India’s position on OECD MC and commentary - PE

23. Implication of India’s position on OECD MC and commentary • Guide to taxpayers on likely approach of Indian tax authorities • India’s tax treaty policy in future tax treaty negotiations/renegotiations • Could it be regarded as an aid for interpreting tax treaties by Courts in India? • Tax treaties entered into prior to July 2008 • Tax treaties entered post July 2008 • Ambiguity/uncertainty in some of India’s positions - use of ‘in certain circumstances’ while expressing reservations • Significant departure from OECD’s position on some key aspects • Cause of concern for foreign companies doing business in India on the extent of deviations they may encounter in application of a tax treaty

24. UN model • Tax treaties between countries with unequal economic status - Developed and lesser developed countries, or between developing countries • Drafted in 1980, designed to encourage flow of investments from the developed to developing countries • Is a compromise between source principle and residence principle • Gives more weightage to source principle, i.e., income should be taxed where it arises

25. Differences between OECD and UN

26. Differences between OECD and UN

27. Differences between OECD and UN

28. US Model • Seeks to align OECD model articles with US tax laws and policies • Only model which USA uses as a basis of negotiating treaties with its other treaty partners • Significant differences as compared to OECD MC • Unlike OECD MC, US MC covers "citizenship" as one of the criteria for determining residency. As per OECD MC for determining residency of a person other than an individual who happens to be a resident of both the Contracting States, place of effective management is the decisive criterion. However US MC specifically provides that in case of dual residency a company shall be deemed to be a resident of the Contracting State where it is created or organised. • In PE context US MC contains an express rule on exploratory activities

29. India’s tax treaties • India’s tax treaties based on a combination of the OECD MC and the UN MC • Emphasis laid more on “source” country taxation which is consistent with the objective and rationale of the UN MC • Certain provisions are unique to India’s tax treaties and are not based on any MC • Broader “Service PE” rule as compared to UN MC • Service PE threshold of six months in UN MC and 90 days in India-US; Services rendered to related enterprise can also trigger PE in India’s tax treaties • “Agency rule” extended to cover a dependent agent “securing orders” • UN Model covers only “concluding contracts”

30. Interpretation of Treaties

31. Vienna Convention on the Law of Treaties • Vienna Conventions codifies existing norms of customary international law with some necessary gap-filling and clarifications • Applies to all international treaties including tax treaties • The Vienna Convention on the Law of Treaties (VCLT) was codified in 1969 and entered into force in 1980 • 108 states have ratified the VCLT (May 2007) • The scope of the Convention is limited • Given due weightage by non signatories • Applicable to both past and future treaties • Growing number of decisions in international courts refer to the rules in the Vienna Convention

32. Articles of VCLT • Article 26 of VCLT – Every treaty in force is binding upon the parties to it and must be performed by them in good faith • Article 31(1) of VCLT - A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose • Article 31(2) of VCLT - Context is defined to include texts and subsequent agreements/instruments related to the treaty

33. Articles of VCLT • Article 31(4) of VCLT – Special meaning only if specifically intended by parties • Article 32 of VCLT - Supplementary means to be used only to confirm the meaning • Article 33 of VCLT - Treaties authenticated in two or more languages • Article 34 of the VCLT – A treaty does not create either obligations or rights for a third state without its consent

34. Tax treaty vs. Domestic law Distinguishing features

35. Tax Treaty Interpretation Rules • Whether treaty can impose tax or provide higher burden than under domestic law : • No. Treaties only have a negative effect: “a tax treaty neither generates a tax claim that does not otherwise exist under domestic law nor expands the scope or alters the type of an existing claim” (Vogel) • Treaties aim at limiting the Contracting States’ tax claims based on their internal legislation • Hence, when investigating the tax implications of a given fact in connection with two States: • First, an internal rule must impose taxation • Then, it will have to be determined if that tax claim is negatived or limited by a treaty

36. Aids to interpretation

37. Reference to domestic law under Article 3(2) • OECD/UN model conventions and commentary • Protocols • Technical memorandum • Parallel treaties • Indian Judicial precedents • International case laws Aids to interpretation

38. Domestic law as Aids to interpretation • Article 3(2) of the India – UK Tax Treaty “As regards the application of this Convention by a Contracting State any term not otherwise defined shall, unless the context otherwise requires, have the meaning which it has under the laws of that Contracting State relating to the taxes which are the subject of this Convention.” • Meaning under “tax law” to be preferred over meaning under other laws

39. Domestic law as Aids to interpretation • Static v. ambulatory meaning of the terms • Ambulatory interpretation - ITO v LeonhardtAndra Und Partner 21 ITD 607 (Cal Trib) • Static interpretation - Change in incorporating statute not to have effect on incorporated statute, artificial definition not applicable – Siemens Aktiengesellschaft v ITO 22 ITD 87 (Bom Trib.) • Committee of Fiscal Affairs has come down firmly in favour of the ambulatory approach • Commentary on Article 3 of OECD Model amended to make it clear that references to domestic law are intended to refer to such law as it changes from time to time

40. OECD Commentary • What the OECD Commentarysays about its significance • “Member countries…. should conformto this Model Convention as interpreted by the Commentaries thereon … and their tax authorities should follow these Commentaries… when applying and interpreting the provisions of their bilateral tax conventions that are based on the Model Convention.” Para 3 to ‘Introduction to OECD Commentary • “ the worldwide recognition of the provisions of the Model Convention and their incorporation into a majority of bilateral conventions have helped make the Commentaries on the provisions of the Model Convention a widely-accepted guide to the interpretation and application of the provisions of existing bilateral conventions. This has facilitated the interpretation and the enforcement of these bilateral conventions along common lines.” Para 15 to ‘Introduction to OECD Commentary’

41. UN Commentary • What does UN Commentary say about its significance? “ Like all model conventions, the United Nations Model Convention is not enforceable. Its provisions are not binding and furthermore should not be construed as formal recommendations of the United Nations… If the negotiating parties decide to use in a treaty wording suggested in the United Nations Model Convention, it is to be presumed that they would also expect to derive assistance in the interpretation of that wording from the relevant Commentary. The Commentaries, which may prove to be very useful in the implementation of a treaty concluded by the negotiating parties and in the settlement of any dispute relating thereto, are not intended to be annexed to such a treaty, the text of which in itself would constitute the legally binding agreement.” Para 35 & 36 of Introduction to UN Commentary

42. Reliance on MC Commentary – Indian perspective • Approving reference to OECD/UN commentary • OECD/UN MC or Commentary have generally received ‘due respect’ • The OECD / UN Model or Commentary play a “key role” in interpreting tax treaties • They constitute “international tax language” • The meanings assigned by OECD / UN Model or Commentary should be given “due weightage” • Courts have frequently ‘referred’ to the OECD/UN MC or Commentary • to ‘reinforce’ / ’confirm’ its conclusion, • to draw support for its conclusion and • in certain cases, even ‘followed’ the MC or Commentary Union of India v Azadi Bachav Andolan 132 Taxman 373 (SC); Graphite India Ltd. v. DCIT 78 TTJ 418 (Cal.); CIT v Vijay Ship Breaking Corpn. 261 ITR 113 (Guj); CIT v Vishakapatnam Port Trust 144 ITR 146 (AP); DCIT v ITC 85 ITD 162 (Cal.)

43. Reliance on MC Commentary – Indian perspective • Disapproving reference to OECD/UN commentary • P. No. 28 of 1999 242 ITR 208 - AAR “refused” to follow the OECD Commentary observing that it is “contrary to the well-established principle of statutory interpretation” • CIT v Vr.S.R.M.Firm and Others 208 ITR 400 (Mad) - Observations may give an impression that reliance upon the OECD Commentary is “inappropriate” and “unjustified”

44. Reliance on MC Commentary – Indian perspective Reliance placed by the Indian Revenue on the OECD Commentary • Indian Revenue has itself placed reliance on the OECD Commentary when it found the Commentary to support its contentions • British Airways Plc. vs. DCIT 73 TTJ 519 (Del) • CIT vs. Vijay Ship Breaking 261 ITR 113 - Gujarat High Court “followed” the OECD Commentary while deciding against the taxpayer Conclusion • Both tax payers/tax authorities have been liberally referring to the OECD/UN MC and Commentary to support their respective claims • Courts have generally accepted them as an important ‘aid for interpretation’ of tax treaties

45. Aids to interpretation - OECD/UN Commentary • Relevance of the “revised” OECD / UN Commentary in construing a treaty signed “prior” to the revision • P No 30 of 1999 238 ITR 296 - AAR held that a “useful reference” could be made to the revised OECD Commentary and that the tax treatment “has to conform” to the revised Commentary “to accommodate the emerging developments” • Many amendments are intended to simply clarify, not change, the meaning of the articles or the commentaries, and such a contrario interpretation would clearly be wrong in those cases– OECD Commentary

46. Aids to interpretation- Parallel treaty/protocol • Philip Baker in his treatise ‘Double Taxation Convention’ comments as follows: “There is no reason why parallel treaties should not be referred to, but their value as aids to interpretation will generally be low” • Reliance placed by Supreme Court on India-US treaty (‘Limitation of Benefit Clause’) while opining on treaty shopping • Indian judgments where reliance placed on definition in a parallel treaty or its protocol • Raymond Ltd. v DCIT 80 TTJ 120 (Mum) • C.E.S.C. v DCIT 80 TTJ 806 (Kol)(TM)

47. Unilateral material/Other Aids to interpretation • Technical memorandum prepared by the US Treasury are often referred in the US as an aid to interpretation • “Common interpretation – Where a treaty is held to have a particular meaning in one state, it is desirable that it has the same meaning in the other state” (Baker) • Relevance of treaty negotiation materials • Relevance of foreign judgments Not legally binding although useful reference for common interpretation Trend in India – Even for typical domestic law interpretation issues reference is made to parallel treaties and foreign judgments

48. India-Mauritius Tax Treaty - Validity Supreme Court of India Ruling in the case of Union of India vsAzadiBachaoAndolan Facts • The CBDT, in connection with companies seeking to avail the tax benefits under the India‑Mauritius Tax Treaty, had issued Circular No 789, wherein it was clarified that the issue of a tax residency certificate by Mauritius tax authorities was sufficient evidence of residence and beneficial ownership and hence the treaty benefits could not be denied. The validity of this circular was challenged in the Supreme Court in the case of Union of India vsAzadiBachaoAandolan. Decision • The Supreme Court laid out certain important principles and held as follows: • Every country seeks to tax the income generated within its territory on the basis of one or more connecting factors such as location of the source, residence of the taxable entity, maintenance of PE, etc. The power to enter into the Treaty is an inherent part of the sovereign power of the state. The Act of Parliament has been translated by enacting applicable provisions in the local tax legislation, permitting non-resident to avail Tax Treaty benefits, if these were more beneficial.

49. India-Mauritius Tax Treaty - Validity Supreme Court of India Ruling in the case of Union of India vs Azadi Bachao Andolan (cont’d) Decision • Circular No 789 is consistent with the provisions of section 90 of the Act as section 90 is specifically intended to enable and empower the Central Government to issue notifications for implementation of tax treaties and hence the circular in not unfounded. • The Supreme Court further observed that if the national of a third country should be precluded from the benefits of the treaty, suitable limitation should have been incorporated in the Treaty. Hence, residents of the third contracting states cannot be denied the benefits on the grounds that treaty shopping is unethical or illegal. The Supreme Court held that courts have to see what the law is and apply the same, rather than making the law. • The Supreme Court concluded that interpretation of treaties is not the same as that of statutory legislation. Tax Treaties are negotiated and entered into at a political level and have several considerations as their bases. In developing countries, treaty shopping works as a tax incentive to attract scarce foreign capital or technology. The concept of granting tax concessions is similar to tax incentives granted by developing nations such as tax holidays, grants, etc.

50. India-Mauritius Tax Treaty - Validity Supreme Court of India Ruling in the case of Union of India vs Azadi Bachao Andolan (cont’d) Decision • The Supreme Court held that an Act which is valid in law cannot be treated as illegal and prohibited merely on the grounds that there is some underlying motive, which would result in economic detriment to the national interest. • In summary, on the basis of the above ruling, in the absence of a limitation of benefits clause contained in the India‑Mauritius Tax Treaty, treaty shopping is not illegal. The Supreme Court has also upheld Circular No 789 issued by the CBDT, which clearly states that a tax residency certificate issued by Mauritius tax authorities was sufficient evidence of residence as well as beneficial ownership and accordingly, the provisions of the India‑Mauritius Tax Treaty can be applied. Further, Tax Treaties can be entered into for other reasons besides tax reason such as for attracting scarce foreign capital